Avoid tapping 401(k) to pay mortgage

Gail MarksJarvisTribune staff reporter

Q: I understand that there is a new law that will let people pay their mortgage by using their 401(k) savings. Is that a good idea? -- S. T. Minneapolis

A: U.S. Senator Norman Coleman, of Minnesota, has sponsored a bill that could give some struggling homeowners leeway to borrow from their 401(k) retirement savings at work, or IRAs, to cover mortgage payments they cannot afford.

But, at this point, the measure is little more than a proposal. It has not been passed into law. And unless it is passed, you will take on a lot of risk if you borrow from your 401(k) to bail yourself out of a mortgage problem. Even if the law passes, there will be risks. So I would not suggest touching your 401(k) money if you can possibly avoid it.

People are much too quick to borrow from their 401(k)s. They see a stash of money building up, and when times get tough or they want something like a car or vacation, they apply simplistic logic. They say: What's the harm in borrowing from myself?

But that's naive thinking, without appreciating the repercussions.

When you borrow from a 401(k) plan you can relieve yourself of the pressure of one emergency but create another.

Under existing federal law, people are allowed to borrow from their 401(k), but the intent is to let you borrow only for the short-term. Under the law, you are expected to pay the money back, and you are given no more than five years to do it. If you lose your job, you have to pay it back quickly--usually within 90 days.

If you fail to pay the money back on time, you have to pay taxes on everything you owe. In addition, there will be a 10 percent penalty. This is a lousy way to get your hands on quick money. For example, if you were in the 25 percent tax bracket, took out $10,000 and didn't repay it, you would only get your hands on $6,500. You'd have to turn $3,500 over to Uncle Sam.

When people are tempted to borrow, they tell themselves that they will certainly be able to dig up enough money within five years. It was precisely that wishful thinking that enticed some people into taking on mortgages they would not be able to afford long-term.

If your mortgage is unaffordable now, it might be unaffordable in a few years, so repaying a 401(k) loan may be tougher than you now imagine.

Even worse, the economy is growing weaker and analysts think layoffs will become more frequent. If you are laid off, the last thing you will want to do is pay back a loan. Even if your job is secure, you never know what might happen. If you are in a car accident, and can't work, do you want to worry about how to repay a 401(k) loan?

The rules on 401(k) loans are set by both the federal government and individual employers, so there can be some variation. Usually you can't borrow more than half of what's in your 401(k).

If Coleman's bill becomes law, people who are 60 days late on their mortgage payments will be allowed to take as much as $100,000 out of their 401(k) without the 10 percent penalty. While the penalty will be waived, they will still owe income tax on the money if they do not replace it in the 401(k) plan within three years. There would be income limits on such loans. For singles incomes would have to be under $114,000 and for couples $166,000.

Before borrowing from a 401(k) plan under the old rules, or if the Coleman measure passes, be aware of the following.

If you are in very serious financial trouble, borrowing from a 401(k) can be a tremendous mistake, said Odette Williamson, an attorney for the National Consumer Law Center. People sometimes try to avoid bankruptcy by taking money out of their 401(k), but if they end up in bankruptcy anyway, they will find they gave up their money needlessly. The bankruptcy court forces people to use some of their assets--even their homes--to repay credit card companies and other lenders. But the court does not require people to use any of their 401(k) money to cover their debts.

There is a good reason why: If people do not save enough money for retirement they are likely to be a burden to society in their old age. The government would prefer to avoid such financial pressures.

Further, people who are not in dire straits fail to realize what they do to their future when they borrow 401(k) money.

Because money is removed from their 401(k) for up to five years, they cannot earn as much interest as they would otherwise. That may not seem like a major sacrifice. But after many years, that loss adds up to a large sum.

If a 35 year-old removes $10,000 from a 401(k) and pays it back within five years, the impact of missing five years could be a loss of $28,000. If the person were to decide to use the $10,000, and not repay it to the 401(k), they could lose about $122,000 by forgoing an 8 percent investment return on their money. Try your own calculation at http://www.bankrate.com/brm/calc/401kl.asp. Then, consider that if you go into retirement with $500,000 in savings, that will give you only about $20,000 a year for living expenses. (That $20,000 is 4 percent of your savings a year. That's considered a prudent approach in retirement--an approach that generally ensures that you won't run out of money before you die.)

Meanwhile, instead of borrowing money from your 401(k), consider other options first. Perhaps negotiating better terms with your lender, or taking on a second job, would be a better long-term solution.

Gail MarksJarvis is a Your Money columnist. Contact her at gmarksjarvis@tribune.com.